Trichet: Carney risks “enormous volatility”

In an exclusive interview, the former head of the ECB says the eurozone is past the worst

Trichet: “the risk of dramatic events in the euro area has considerably alleviated”

Finally, there is some good news from Europe. Jean-Claude Trichet, the former President of the European Central Bank, believes that the crisis in the eurozone has moved out of its most dangerous phase. Speaking exclusively to Prospect, Trichet, who until 2011 was the most powerful central banker in Europe, said that the “risk of dramatic events in the euro area has considerably alleviated.” The eurozone crisis has held back the British and global economies from returning to health after 2008. If Trichet is right, we could be seeing the start of Europe’s economic recovery.

However, Trichet’s comments also contained a warning for Britain, specifically about the “forward guidance” policy being introduced by the new Bank of England Governor, Mark Carney. The policy, Carney’s first major initiative at the bank, means he will give a public forecast of future UK interest rates. Trichet warned that this risks creating “enormous market volatility,” due to the distorting effects it could have on global markets.

The suggestion that Bank of England policies could cause instability in UK and global markets will be extremely unwelcome for the central bank and the government. The appointment of Mark Carney has been seen as a great success for George Osborne. But Trichet suggested that the new policies will encourage currency speculators to take risky bets on the pound, threatening the stability of the sterling and the UK’s fragile economic recovery, on which the government’s hopes of re-election rest. The consequences for the British public could be substantial.

On the eurozone, Trichet said that a combination of reform and changing market sentiment had caused the outlook to improve. Countries that had faced the worst of the crisis—Greece, Portugal, Spain, Italy and Ireland—have reduced spending and are no longer running up big international debts. The health of the eurozone has also been bolstered by its political resilience. “There was no democracy in Europe that wanted a change in the composition of the euro area, either countries choosing to leave… or countries calling on others to leave,” he said.

But can the eurozone continue in its present state? Germany is a huge manufacturer and exporter with a large economic surplus. By contrast, the countries of the south are importers and ran up deficits in part to pay for those imports. That imbalance is a significant weakness.

“Don’t forget that when we started the euro, Germany had a current account deficit,” said Trichet. “The overall constellation of surpluses and deficits was totally different.” As the eurozone recuperates, it is important to have “very solid governance at the centre,” to help maintain a more even economic landscape.

And should that “solid governance” include a banking union, in which all European banks are supervised by Brussels? Should there also be “debt mutualisation,” where eurozone countries borrow from markets as a bloc, by issuing eurobonds? “Certainly [there should be] a banking union, which has already been decided in principle,” he said, and “certainly a very close monitoring of fiscal policies.”

Trichet also noted that a banking union would include a Europe-wide rescue fund, to bail out troubled banks. This would entail “limited partial debt mutualisation.” The European Stability Mechanism, which has been established by treaty, also means that European nations are beginning to share the risk posed by their banks.

But although Trichet sees a certain degree of economic integration as inevitable, he stops short of predicting full budgetary union—nations will not give up power over their domestic spending. “The idea that you could merge… the various national budgets of the euro area countries seems to me both totally impossible and unadvisable,” he said. “You have no federation in the world which is applying such a concept.”

But some European countries have already ceded control of their budgets. Greece has been prescribed a strict dose of austerity by the Troika—the European Central Bank, European Council and International Monetary Fund—which insisted the country cut spending in order to get bailout funds. Trichet was clear: “In countries that have had difficulty financing themselves because there has been a dramatic loss of confidence from savers and investors abroad, both in terms of current account and in terms of fiscal position, then clearly there is not much choice.” Nations that find themselves with rising borrowing costs must “take into account that the rest of the world is demonstrating its intention not to continue to finance eternally your deficits.”

“When an economy is spending much more than it earns, going back to a sustainable situation is always painful,” he said.

On Britain’s relationship with Europe, Trichet said, “I have no doubt that the UK remains a European country. I am absolutely sure of that… the UK is welcome, not only in the EU, but also in the euro area.”

As for Carney’s new approach, Trichet was critical. “I have always been prudent as regards forward guidance,” he said. It is important to ensure that statements about the future direction of interest rates are not misinterpreted, and to understand that circumstances—and therefore forward guidance—could change. Considering that such changes are always possible, “I am not convinced that the medium-term impact of forward guidance is significant,” he said.

But his strongest criticism was the danger of telling markets the level at which the Bank of England will set interest rates and for how long. Then, said Trichet, “not only one would risk an inflation surge later but traders will embark immediately on very large scale carry trade.” A carry trade is the process of selling the currency of a country that has low interest rates and buying bonds denominated in a currency offering a higher rate. The margin between the two rates is taken as profit. In telling financial markets that British interest rates will remain low, Carney risks encouraging the use of sterling as part of a carry trade. This kind of trade can be lucrative, but carries a high degree of risk. “And when a significant part of this carry trade abruptly ends, then it creates an unwelcome, enormous market volatility.”

Trichet concluded that forward guidance “is one of the indicators signaling that all advanced economies have still to cope with the ongoing consequences of the crisis.”

“Governments, parliaments, public authorities in general and the private sector still have a lot of homework to do,” he said, before economic health is restored to Europe, and the global economy.

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